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How This Works

An Overview:

In its simplest explanation, leveraged buyouts use the balance sheet of the business to create the cash and you use the income statement to pay for the cash that is used to acquire the business.

Let me walk you through an overview of an actual transaction (on this one I'll round the numbers to make it simpler to follow).

One of my funding sources sends out a monthly newsletter and recently sent a little news item on providing funding for the $300,000.00 purchase of a small manufacturing business.

Here is a financial summary of the business the buyer wanted to buy:

From their Balance Sheet -

• The business had $100,000 in accounts receivable.

• The business had about $200,000 in equipment.

• The business real estate was worth about $225,000.

Here is how those assets were used to come up with the purchase price to buy the business:

The buyer was able to use those assets in this way -

• The buyer sold the accounts receivable to a firm that buys receivables for $85,000.

• A funding source was able to lend the buyer $100,000.00 against the value of the equipment

• The funding source was able to lend the buyer $135,000.00 against the value of the real estate.

The total amount the funding source was able to provide the buyer was $320,000.

The purchase price was $300,000 and the buyer allocated the surplus $20,000 to be used for additional working capital for the business.

The buyer did not have to put any of their own money into the deal.

And the cash flow from the business was more than enough to pay the buyer for the new debt (for the loan against equipment and real estate) and also to pay themselves a salary to own and manage the business.

Now the above was somewhat unusual since most small to mid-sized businesses sell with the owner carrying a major portion of the financing. In a typical transaction there will be a 25 percent cash down-payment and often the remaining 75 percent is financed by the business seller over five, seven, ten or more years.

One thing that's very important to understand (as par of the negotiations in any deal) is that if you do not satisfy the seller's needs, then you'll not be able to close the deal.

A business owner that has owned their business for ten, fifteen, twenty or thirty or more years is going to be concerned about one thing, and one thing only if they carry back any financing; security.

Whether they mention that or not it; security is going to be a very critical item and concern in their mind.

You have to structure a deal that works and put together an offer that's going to be acceptable to the seller.

In order to do that you have to understand exactly what it is that you have to work with.

The way that you address their concerns and make them feel comfortable in doing a deal with you is to look at your financial tool-kit of resources to draw upon to structure your deals and see how to apply them to each deal that you are considering.

There are numerous tools to help you with the financial structuring of your deal that we will get into detail about in the section on Deal Structure but basically your tools fall into two categories:

1. Cash creation, and
2. Cash deferral:

Cash creation tools utilize the balance sheet accounts receivable, notes receivable, inventory and fixed assets.

Cash deferral tool are installment notes, earn-outs and royalties and agreements with the seller such as a non-compete and consulting or employment agreements. Another useful cash deferral tool is perk packages that can be created to provide value to the business seller without the buyer having to use cash.

Important Note

In another post about deal structure, at another time, I will go over details. But in the following overview we talk about selling "this" and borrowing against "that" ... these are all things that are done within the buy/sell agreement and actually get consummated at closing from escrow. You will be arranging these things before closing once you have your agreement with the seller in place but again it is important to understand that they will be finalized as part of the closing process

Deal Example:

Here is a more detailed example of actual deal structure that uses some of the cash creation and cash deferral tools. We'll refer to this deal as "FabCo". I have this available for download as a completed deal review spreadsheet titled "FabCo Detailed Deal Example" if anyone wants to contact me and ask for it:

Established Components Manufacturer

$5 Million in revenue

$1 Million in true net income

Transaction Value: $4,350,000

Cash Down-payment: $1,000,000

The business generates a little over 5 million in revenue and has net income of approximately $1 million per year.

It's important to understand when you're doing leveraged buyout deals that the seller generally sets the price and the buyer usually sets the terms.

After the initial discussions and negotiations on this transaction it was determined that they would accept the purchase price of $4,350,000.

Explanation of the Deal Example and step-by-step how it worked:

Now we need to start reviewing how we could structure an affordable deal to get to that price. This starts with reviewing the balance sheet:

I'm going to start with the assets at the top of the balance sheet. This is generally where you would look in the balance sheet to create the down-payment (the income statement is where you look for the cash flow to support any new debt).

Remember assets in the balance sheet are organized by their nearness to cash so you start with $260,957.

Your offer to the seller would include that they "sell" you their cash.

Why would a business owner want to do this? Easy answer. The tax consequences are less if they sell that cash to you as an asset of the business and have it treated as capital gains when you pay it back to them as part of the purchase price of the business. If they take the cash out of the business depending on their business structure; then they either will pay corporate or personal income tax on it ... if they are a business entity that has to pay corporate tax ... they may have to pay taxes twice; once as a corporation and then again as personal income.

Capital gains taxes are usually much lower and this is why it makes sense for the business owner to "sell" you the cash.

Next are accounts receivable of $755,850; remember these are very close to cash. Then there is $1,031,466 in inventory and fixed assets valued at $2,892,342.

Here's what was done with those assets in order to generate cash to come up with a down-payment:

The accounts receivable were sold to a factor for 80¢ on the dollar (a factor is a financial entity that buys accounts receivable at a discount; another thing that could've been done would be to borrow against them but that creates debt you have to service). When you sell accounts receivable to a factor you get roughly 80¢ on the dollar so $604,679.67 was received from selling these accounts receivable to the factor.

Adding that to the $260,957.47 in cash now gives us $865,637.14 to use towards buying FabCo.

We looked at inventory and determined that fully 50% of the inventory was surplus and not immediately needed to operate the business. This is not an uncommon thing to find in small to medium sized businesses. Owners frequently "hide" earnings by carrying inflated inventory levels and often inventory tends to pile up if the business owner is not particularly disciplined in managing inventory levels.

Again, this is fairly common which is why inventory is often a very useful tool in creating cash for deal structure (more about this in the section on deal structure).

The supplier was willing to buy back 50% of the inventory at about a 1% discount with a guarantee that the buyer as new owner would re-purchase it from them. This created $500,260.78 to add to the funds accumulating to purchase FabCo.

At this point no money has been borrowed and no new debt created and we now have $1,365,897.92 built up to go towards buying FabCo.

But we are still short of creating enough money to buy FabCo. We need now to turn to some of the fixed assets to see if we could produce and generate more cash to go towards the deal

This is the point in the deal structure where we create new debt that has to be serviced from cash flow.

We took the fixed assets; the furniture fixtures & equipment value of $2,892,341.93 and arranged asset based funding of 20 percent of the appraised value of those assets. This created $578,468.39 to add to our funds bringing that up to $1,944,366.31 in cash available to go towards buying FabCo.

Now with what we have created for cash we have enough to support a reasonable down-payment and we can formulate the structure of an offer.

The seller agreed to accept a $1,000,000.00 cash down payment.

The balance of sale to be paid out as follows:

The seller would carry an installment note of $2,000,000 at 7.5% for 20 years (payments of $16,111.86 monthly).

The seller would receive an Earn-Out agreement that paid him $100,000 per year for 5 years for a total value of $500,000.

The seller would receive $80,000 per year for their non-compete agreement for 5 years for a total value of $400,000.

The seller would remain working part-time in the business for an employment agreement that paid them $40,000 per year for 5 years for a total value of $200,000.

As part of their agreement the seller would also receive a perk package of $50,000 per year for 5 years for a total value of $250,000.

Let's recap this:

$1,000,000 cash down-payment

$2,000,000 installment note

$ 500,000 earn out agreement

$ 400,000 non-compete agreement

$ 200,000 employment agreement

$ 250,000 perk package

Total value to seller: $4,350,000

To provide FabCo with the $1,000,000.00 cash down-payment we took $1,000,000.00 in cash from the $1,944,366.31 that was created from the balance sheet.

Remember what we said earlier about owners really having a concern over security?

The owner was understandably concerned about the security of the $2,000,000 that was going to be financed over twenty years.

So the deal structure had to address that concern. This is how that was done:

You may not be aware of this but insurance annuities are used in many different ways other than what you would normally think.

They are used by corporations as a way to settle lawsuits or as payment plans to pay for judgments and damages. They are used by state lotteries to create the structured payments that go to lottery winners that don't take a lump sum payment.

That is done with what are called "single premium" annuities. A single payment (the premium) is prepaid to buy the annuity at a current discount. The insurance company then becomes the guarantee that payments are made over a defined period of time.

For this transaction a single premium annuity was purchased for about 35¢ on the dollar. For a $2,000,000 pay out over 20 years the buyer paid $700,000 at closing.

Again, now the insurance company guarantees the payment and the business seller did not need to look to the buyer or the business assets for security on the installment note.

By the way, doing this also means that the installment note debt does not have to be serviced by the business cash flow.

Let's break this down so that you get the real picture of while was just accomplished

For an approximate cash cost of $1,700,000 the business owner/seller was given a purchase price value of $4,350,000 and the company under new ownership was actually left with over $244,366.31 to go towards additional working capital for the business .

The new debt service for the business came to approximately $438,000 per year which is more than serviced by the $1,000,000 in annual net income from the Income Statement.

In approximately 5 years all debt and obligations to the former business owner will be paid in full.

And the buyer did not put any of their own money into the transaction.

The above is a real example of how LBOs work on small to medium sized businesses.

For those of you interested, let me know and I will try and post more information on this subject.